Stock Interests - Grandfathered Valuation Rules

[Christine Roberts]

A newly hired executive and the employing closely held coroporation enter into an undated "proposed" term sheet in late 2003.

Term sheet proposes "equity participation" equal to a 5% grant of shares outstanding at 1/1/2004, and stock options equal to 15% of the company based on fiscal year end values (April 30 of 2004, 2005 and 2006).

The "equity participation" shares vest in 1% increments at 6 months, 12 months, 18, 30 and 42 months, such that shares equal to 2% are vested and nonforfeitable as of December 31, 2004. No shares actually change hands nor is any additional compensation provided to the executive at any time.

The options vest in 5% increments at June 30, 2004, June 30, 2005 and June 30, 2006; each increment expires after 10 years. Thus options equal to 5% are vested as of December 31, 2004. No further documentation of the options is made.

Fast forward to 2010; parties to "proposed" term sheet want to give it effect to the extent possible and primarily desire to continue deferral of the options and "equity participation"/appreciation rights to extend until change in control of closely held company.

To the extent the term sheet constitutes an "issue" or "grant" of stock rights before January 1, 2005, all stock rights would appear to be entitled to "grandfathered" valuation rules under Notice 2006-4 which states in relevant part:

"Until further guidance is issued, with respect to a stock right issued before January 1, 2005, for purposes of determining whether the stock option results in a deferral of compensation pursuant to Notice 2005-1, Q&A-4(d)(ii), or the stock appreciation rights results in a deferral of compensation pursuant to 1.409A-1(b)(5)(i)(B) of the proposed regulation, prinviples similar to those set forth in Sec. 1.422-2(e)(2) will be applied. Accordingly where there was a good faith attempt to set the exercise price of a stock right granted before January 1, 2005, at a price not less than the fair market value of the stock subject to the stock right at the time the stock right was granted, that such exercise price will be treated as being not less than the fair market value of the stock at the time of grant for purposes of determining whether the stock right is excluded from the requirements applicable to deferred compensation under section 409A."

As grandfathering of valuation method = all stock rights, whenever "vested" are deemed to be non-discounted and hence not subject to 409A, is the whole arrangement exempt from 409A and thus capable of being revised and restated at any time in any way the parties see fit?

[Christine Roberts]

A newly hired executive and the employing closely held coroporation enter into an undated "proposed" term sheet in late 2003.

Term sheet proposes "equity participation" equal to a 5% grant of shares outstanding at 1/1/2004, and stock options equal to 15% of the company based on fiscal year end values (April 30 of 2004, 2005 and 2006).

The "equity participation" shares vest in 1% increments at 6 months, 12 months, 18, 30 and 42 months, such that shares equal to 2% are vested and nonforfeitable as of December 31, 2004. No shares actually change hands nor is any additional compensation provided to the executive at any time.

The options vest in 5% increments at June 30, 2004, June 30, 2005 and June 30, 2006; each increment expires after 10 years. Thus options equal to 5% are vested as of December 31, 2004. No further documentation of the options is made.

Fast forward to 2010; parties to "proposed" term sheet want to give it effect to the extent possible and primarily desire to continue deferral of the options and "equity participation"/appreciation rights to extend until change in control of closely held company.

To the extent the term sheet constitutes an "issue" or "grant" of stock rights before January 1, 2005, all stock rights would appear to be entitled to "grandfathered" valuation rules under Notice 2006-4 which states in relevant part:

"Until further guidance is issued, with respect to a stock right issued before January 1, 2005, for purposes of determining whether the stock option results in a deferral of compensation pursuant to Notice 2005-1, Q&A-4(d)(ii), or the stock appreciation rights results in a deferral of compensation pursuant to 1.409A-1(b)(5)(i)(B) of the proposed regulation, prinviples similar to those set forth in Sec. 1.422-2(e)(2) will be applied. Accordingly where there was a good faith attempt to set the exercise price of a stock right granted before January 1, 2005, at a price not less than the fair market value of the stock subject to the stock right at the time the stock right was granted, that such exercise price will be treated as being not less than the fair market value of the stock at the time of grant for purposes of determining whether the stock right is excluded from the requirements applicable to deferred compensation under section 409A."

As grandfathering of valuation method = all stock rights, whenever "vested" are deemed to be non-discounted and hence not subject to 409A, is the whole arrangement exempt from 409A and thus capable of being revised and restated at any time in any way the parties see fit?

For answer to above qusttion to be "yes" the term sheet must meet the definitions of "option" and "date of grant of option" set forth in Treas. Reg. Sec. 1.409A-1(b)(5)(vi)(A) and (B), respectively, which are equally applicable to stock appreciation rights under (vi)(H). The definitions require that, among other items of information, the maximum number of shares subject to the option/appreciation right be stated in writing or electronic form. If this information is not part of the term sheet, or part of a writing/email, etc. that can be proven to have been made contemporaneously to the term sheet (I don't think there is any requirement that all required items of information be part of the same document), the pre-2005 actions were incomplete, for grandfathering purposes.

Any comments appreciated.